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TRADERS WRESTLED WITH A RIDDLE LAST WEEK while awaiting the U.S. government's stress-test results for the nation's largest banks. The correct answer surprised many.

Here are the "facts": A major bank denies needing more capital. Washington policymakers anonymously tell reporters that the bank needs about $34 billion.

About six months ago, the chief executive of this bank bought a major brokerage firm that some critics now fear could prove a Trojan horse. Before the bank's recent annual meeting, the U.S. Treasury secretary and the chairman of the Federal Reserve allegedly tell the CEO not to reveal details of potential problems with the deal. The Fed chairman, Ben Bernanke, denies an attempt to silence the bank boss.

At the meeting big investors try to oust the bank's current directors, but fail. They succeed, however, in stripping the CEO of his chairman title.

Given these events, would a trader be correct to:

A) Conclude that the embattled CEO has been victimized by circumstance, and aggressively buy bank shares and calls because the stress-test results will indicate that the financial crisis is over? Or B) Smell big trouble in the tale above, sell stock and buy puts to profit from the stock's decline?
Bank of Americabac 1.6836508639787329%Bank of America Corp.U.S.: NYSEUSD22.95
0.381.6836508639787329%
/Date(1481234432480-0600)/
Volume (Delayed 15m)
:
181368365AFTER HOURSUSD22.96
0.01000000000000160.04357298474945534%
Volume (Delayed 15m)
:
1325523
P/E Ratio
19.13297207169654Market Cap
232342244198.49
Dividend Yield
1.3071895424836601% Rev. per Employee
432244More quote details and news »bacinYour ValueYour ChangeShort position
(ticker: BAC), you might well have guessed, is the subject of the riddle, and the right answer, it turned out, was A. That confounded many options traders, who thought the stock would fall. By midday Friday, the stock's weekly gain was some 60%.

"Everyone's gotten hurt on this. It's very odd," one trader said. "You'd think equity would decline because it will be diluted [when the bank sells more stock to raise capital.] But everyone is under-invested," so chasing rising stocks will continue.

Now that the riddle has been solved, many traders and strategists think they can make money positioning for a decline in Bank of America's options volatility. This view is supported by recent tightening of the bank's credit-default swap spreads. CDS spreads correlate with options volatility, and tightening credit spreads suggest less investment risk, which can be good for the stock.

Investors who think the stock will advance can sell out-of-the-money puts that expire in one to three months, to profit from declining volatility. But there's a risk they'll have to buy the shares if they advance below the puts' strike price.

Those who think the stock may decline, or stall, can "overwrite," or sell calls against the stock, but this strategy is potentially problematic. Many investors bought Bank of America shares at higher prices, so overwriting could force them to lock in losses if the stock continues to rally.

NOW THAT THE STRESS TESTS of the nation's banks have left most of those involved just a little less stressed, it's time to get back to business. For the banks, that means raising fresh capital in the public markets, instead of taking handouts from Uncle Sam. For the government -- well, new riddle: What will it fix next?